Another Earnings "Beat" Doesn't Change Short Case For TiVo

| About: TiVo Inc. (TIVO)

As a TiVo (NASDAQ:TIVO) bear (see here and here), I have criticized the stock on a number of occasions, in a number of ways. But even I have to give the company credit for excelling at earnings releases. For the third consecutive quarter, TIVO gapped up after announcing quarterly results, with the stock jumping 6% in after-hours trading Tuesday.

Now, a writer less gracious than myself might point out that the company still lost $25 million, or that the net growth in subscribers was long overdue, given that the company had lost subscribers for fifteen consecutive quarters. But I would never stoop that low. Instead, I'll ask: did Tuesday's earnings release change the TIVO thesis?

First, let's look at the updated balance sheet. The company offers $445 million in cash, net of its convertible debt. It also has two outstanding lawsuits against AT&T (NYSE:T) and Verizon (NYSE:VZ) relating to patent infringement on TiVo's "time warp" patent. The net proceeds from those lawsuits has been estimated at $300 million by the Maxim Group's Mark Harding. According to the Q3 conference call, the AT&T trial should start in January, with a hearing in the Verizon case soon after, which may gave investors more color on the viability - and profitability - of the suits.

For efficiency's sake, we will use Harding's $300 million figure. As I noted previously, the company has no other targets pending (according to SEC filings and conference calls), and its guidance for precipitously lower litigation spend going forward (in the Q3 conference call) would seem to imply that AT&T and Verizon are the last of the major targets. This is important, because the only profitable year in the company's history was 2009, due to initial damages from its case against DISH Network (NASDAQ:DISH). (Based on guidance, TiVo will be profitable again in FY2011, because of its settlement against DISH earlier this year.)

At Tuesday's after-hours close of $10.16, TIVO has a market capitalization of $1.19 billion. Backing out the $445 million in net cash and the $300 million in potential lawsuit proceeds, its enterprise value - the market value assigned to the operating portion of the TiVo business - is $446 million. (The company has a net operating-loss carryforward is expected to be around $500 million at year's end; however, it is difficult to value given the company's distance from profitability and the likelihood that a piece of it will be used in 2012 should legal proceeds from one of the two remaining cases flow into the company's coffers.)

For me, the bear thesis for the stock has been pretty simple: an investor should not pony up his or her share of $446 million for a business that has never, ever, made any money on a stand-alone basis since going public in 1999. And, indeed, at the midpoint of fourth quarter guidance, TiVo in 2011 will lose $112.5 million - $1/share - excluding the proceeds from the DISH lawsuit.

And, quite honestly, despite the enthusiasm surrounding Tuesday's release (CEO Tom Rogers called it "a great quarter"), the third quarter results do little to change my opinion. Yes, net subscriber growth rose sequentially (as noted earlier, for the first time in four years), yet service revenue still dropped as the net gain did not account for lower average revenue per user (ARPU). This is the key challenge facing TiVo as it attempts to reach profitability. Its new third-party deals with operators such as Virgin Media and RCN add new customers, but at substantially lower revenue. In the quarter, TiVo had an ARPU of $8.22 for each "TiVo-owned" (i.e. direct) customer, and $1.65 for each MSO, or third-party customer. As such, the gain of 147,000 MSO accounts could not make up for the loss of 30,000 direct accounts, and revenue fell sequentially despite the headline gain in net customers.

This is partially because of the vast difference in revenue between the subscription types, and partially because third-party ARPU fell strongly from the second quarter, from $1.93 to $1.65. Analyst Barton Crockett of Lazard Capital, noticed and asked about the drop on the conference call's Q&A:

Barton E. Crockett - Lazard Capital Markets LLC, Research Division

I was wondering if you could provide a little bit more discussion of why there was a drop in the average revenue per user in the quarter both at the third-party line $1.65 from $1.93 and also on the stand-alone subs, both have been trending in a different direction for a number of quarters then we saw a reversal here. What happened there? Is it noise or something that continues beyond here?

Anna Brunelle

Yes, this is Anna. I think there are 2 different implications. On the MSO side, you may remember on previous discussions how we've talked about that the DIRECTV minimums were driving at the MSO average ARPU. And as a result of having new subs coming on from other operators, we're seeing that trend back down a bit.

This is a key point that undercuts the bull case for TIVO. Bulls argue that the ARPU will rise (as it has the past few quarters) as more favorable deals - and larger subscriber bases - come online. But the recent figures have actually been inflated by the company's legacy DIRECTV deal (which Brunelle references when discussing "the DIRECTV minimums"). Under that contract, TiVo is paid per subscriber; but DIRECTV is below the minimum number of subscribers, inflating the revenue per user received by TiVo above what it would be otherwise.

Thus, TiVo's issue remains. It must create subscriber growth simply to maintain its current level of losses, because of the tradeoff between TiVo-owned and MSO subscribers. The slow drain on the direct, more profitable customers - 30,000 this quarter, 43,000 last quarter - must be counteracted by six-figure gains on the third-party side simply to maintain the $100 million-plus rate of annual losses.

To actually reach breakeven, the company needs subscriber growth over and above those gains. At a monthly ARPU of $1.65, TiVo needs an additional five million customers just to cover its $24.5 million quarterly loss, disregarding the added expense of those customers. The company had just 910,000 third-party customers at the end of the third quarter.

Assume third-party ARPU will double (a generous, and unlikely, assumption). The company still needs to at least quadruple its existing customer base just to get to breakeven. This is how far TiVo is from profitability. The 15% sequential MSO growth this quarter, while welcome, is not anywhere close to being enough.

How long it will the process take? And how much cash will a company that is losing over $100 million annually burn in the process?

The argument for and against TiVo is rather simple. Bulls point to the success of recently rolled out agreements with Virgin Media and RCN, and new startups with DIRECTV and Comcast. They will argue that now that the company has finally shown net subscriber growth, the new agreements will only accelerate that growth, providing stronger revenues - and margins - as the customer base widens. They look at the company's cash on hand and potential lawsuit proceeds and see a growth stock with a value stock's balance sheet.

The bear case is rather similar. It seems probable that subscriber growth will continue. ARPU and margins will both improve, as a wider customer base creates economies of scale and allows for more creative - and profitable - monetization of the company's advertising capabilities. But it seems unlikely that it will be enough. The road is so long for TiVo: for the business to make money, its customer base must grow by at least a factor of four, or greater. Even the most ardent TiVo bull will admit that such growth would take years. But in the meantime, the marketplace is changing dramatically. Google (NASDAQ:GOOG)'s purchase of Motorola Mobility may give renewed life to Google TV, and Apple (NASDAQ:AAPL) is rumored to be unveiling a new, serious entertainment platform. Convergence is coming, and quickly, and there is no telling whether TiVo will be able to adapt.

TiVo's current management deserves credit for the company's performance this year. They have outstripped not only Wall Street's expectations, but their own, in each of the three quarters. Yet that is precisely the problem with TIVO stock. The company is performing well and ahead of expectations - but it's not enough. Massive subscriber growth is needed, combined with large growth in revenue per user for the underlying business, valued at nearly half a billion dollars, to make a single dollar in earnings. TiVo is closer to the goal than most expected at the beginning of the year. But it is still too far away.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.